Heisenberg Report

‘This Would Very Likely Mark The End Of The Expansion’: Some Trouble With The Curve

“The Fed’s ‘mid-cycle adjustment’ narrative emphasizes that the level of policy rates has now been lowered to levels which should be supportive for growth and, ultimately, inflation”, Deutsche Bank’s Stuart Sparks writes, in a note dated Friday. “This is a Phillips curve argument”.

“The potential weakness of this argument”, he goes on to remark, rather dryly, “is the recent behavior of the Phillips curve”.

The Phillips curve debate has become somewhat “mainstream” in recent years, although “mainstream” is a relative term when it comes to economic models. Suffice to say it’s topical enough to have found its way into Alexandria Ocasio-Cortez’s vernacular, given that the flatness of the curve can be used as an argument for running the labor market much hotter than previously deemed advisable.

Relive the AOC-Powell “faint heartbeat” exchange

“Do you think [the flat Phillips curve] could have implications in terms of policymaking – that’s there’s perhaps room for increased tolerance in terms of policies that have historically been thought to drive inflation?”, the freshman firebrand asked Jerome Powell in July.

“One of the arguments about policies that directly target middle class Americans is that they could drive inflation”, she continued. “Do you think that that decoupling is something we should consider in modern policy making considerations?”

The aim was clear: She was attempting to get Powell to make an economic case for the adoption of modern monetary theory, or, at the least, to compel the Fed chair to admit that some of the standard academic pushback to the kinds of policies that would have the most immediate, dramatic impact on the middle class, may have been invalidated.

“The connection between slack in the economy – the level of unemployment and inflation – was very strong if you go back 50 years and it’s gotten weaker and weaker and weaker to the point where it’s a faint heartbeat”, Powell conceded.

One thing that didn’t come up in that exchange, but which is highly relevant for Fed policy at a time when the committee is clearly inclined to hold off on further easing in the interest of preserving the “mid-cycle adjustment” characterization, is the distinction between how wages have responded to the tight labor market and how prices have reacted to near-record-low unemployment.

Deutsche’s Sparks notes that “wages have begun to rise moderately as unemployment has fallen [but] the price Phillips curve, remains quite flat relative to pre-crisis experience”.

(Deutsche Bank)

The read-through for corporate profits is clear – and somewhat dour. “If wage costs are rising in the absence of rising prices, corporate margins compress and profits decline”, Sparks writes, on the way to highlighting the following chart, which basically shows that pricing power has all but disappeared over the past half-decade.

(Deutsche Bank)

“The point is that the empirically flat Phillips curve could in part reflect an inability to raise prices”, Sparks remarks.

Seen in that light, a continuation of the trend where tight labor markets lead to modestly rising wages will necessarily crimp corporate bottom lines (because those rising labor costs cannot be passed along to consumers).

One “fix” for that situation is simply for management to stop hiring people or, as Deutsche Bank puts it, “the potential remedial action by the corporate sector would be to slow or reverse hiring to restore margins [and] this would very likely mark the end of the expansion”.

Of course, higher productivity could ameliorate the situation (by helping corporates defend margins even as wage costs rise), but productivity growth generally requires investment. Unfortunately, the trade war and attendant plunge in CEO confidence amid rampant uncertainty have contributed to what you see in the following rather stark visual (more here).

That doesn’t appear to bode well, although Sparks points out that “high equity valuations are supportive of investment” two quarters down the road.

The implication for Fed policy would appear to be that a “mid-cycle adjustment” isn’t going to cut it, even if the three rate cuts delivered since July do manage to avert a hard landing.

It’s even possible that if the modest boost to US growth engendered by 75bps worth of cuts serves to exacerbate the economic divide with the rest of the world, the dollar could remain buoyant contributing to more imported disinflation, further imperiling the Fed’s inflation goal.

That’s wholly untenable, because, as Sparks puts it, “higher breakevens, and more specifically the breakeven term premium, are supportive for risk assets and hence are crucial to support investment, productivity, and the viability of the expansion”.

Little wonder, then, that some market participants are reluctant to accept the notion that the Fed is truly “done” cutting rates. Growth may well bottom out, but that by no means ensures a sustainable bounce in inflation, without which the expansion could ultimately fizzle along with the bull market. Clearly, all of this is conducive to a flatter yield curve.

Coming full circle, one way to perhaps ameliorate this over the longer-term is to consider whether the topics and remedies under discussion in the Fed’s ongoing policy review are sufficient, or whether an entirely new approach is called for to foster real vibrancy.

Read more: No Escape From ‘Flattening Vortex’ As Long As ‘Resistance To Redistributive Forces’ Persists, Deutsche’s Kocic Warns